CREDIT RATINGS DOWNGRADES – WHAT ARE THEY ALL ABOUT?

of the rating agencies therefore come from fees that the borrowers pay, to have their bonds rated. (The borrower believes that having a rating – especially a good one – will make it easier to borrow, on favourable terms.)

It is sometimes argued that there is a conflict of interest, in that the rating agencies are paid by borrowers and therefore have an incentive to give their “customers” good ratings. It is thus important that the rating agencies operate with high standards of diligence and integrity. In many countries (including South Africa), financial market regulators also supervise their activities to ensure that they do not, for instance, display bias by giving high-paying customers better ratings.

As some of the investment managers point out, the conflict of interest here is really no greater than when a company hires an audit firm to audit its financial statements, or when a pension fund pays an actuary to assess its financial soundness.

The agencies also provide ratings for bonds issued by governments – so-called “sovereign ratings”. They are not paid by the governments – they do this (without payment) because having a view on the relative creditworthiness of a country’s government debt makes it easier to assess the relative creditworthiness of the country’s other borrowers such as banks.

What is the controversy about the rating agencies’ role in the 2008-09 Global Financial Crisis?

In the years up to the so-called Global Financial Crisis of 2008-09, the investment banks were earning large fees by bringing to the market what we might call “fringe” credit instruments such as specialised bonds backed by pools of residential mortgages or consumer loans, and structured in innovative and complex ways.

Investors, such as large pension funds, were excited by the high interest rates paid by these specialised bonds, but were nervous about their complexity. The investment bank sponsoring the bond would therefore choose a rating agency to give it a credit rating. The investors would be comforted if the bond had a good credit rating such as AAA (“triple-A”) from a reputable agency, and would be more likely to invest.

During the Global Financial Crisis, many such bonds that had been given good ratings went into default. (This highlights that a credit rating of AAA is not the same thing as a guarantee of repayment!) Both banks and investors had been far too optimistic about the quality of the loans underlying these complex bonds, and repayment rates were much worse than expected.

Blame was cast in various directions as pension funds and others who had lost money through this fiasco looked for scapegoats. While the investment banks suffered the greatest reputational damage, the credit rating agencies did not escape.

Accusations were that they were over-confident and had over-estimated their own expertise in assessing such complex debt instruments, or that they had grown too close to the investment banks that were in effect their customers. The rating agencies were certainly all competing for business from a fairly limited pool of clients, which may have sharpened the potential for conflicts of interest.

Both Moody’s and S&P faced actual or threatened lawsuits from lenders and from US authorities, and ultimately paid large settlement amounts in the USA.

Of course this led to heightened regulatory oversight of the rating agencies, as well as their own efforts to “clean up their act”. Paradoxically, greater regulation has made it harder for new firms to compete with the established agencies, which has strengthened their competitive position. An example is Fitch’s recent decision to leave the South African market to Moody’s, S&P and GCR.

What are “sovereign ratings” and why are they important?

All governments have to borrow money from time to time. Most governments have a significant amount of debt outstanding (i.e. borrowings that have not yet been repaid) at any time. Governments are called “sovereign borrowers”, as distinct from commercial entities that are “corporate borrowers”.

Governments will borrow in their own countries, from domestic investors such as pension funds and insurers, as well as from private savers. The bonds that a government issues in its domestic market will be denominated in its own currency – so the RSA Government bonds held by most SA retirement funds are of course denominated in Rands. (Foreign investors can, and do, also buy Rand-denominated bonds.)

Governments will also often borrow from foreign lenders. These borrowings might be denominated in the home currency, but may also be issued in a currency such as the US Dollar or the Euro. The reason is that some lenders in the USA may be willing to lend to the South African government, but may prefer to lend in Dollars so that they do not carry the risk of the Rand weakening.

As mentioned above, the rating agencies issue credit ratings for government borrowers as well as corporate borrowers. The aim is to give an indication of the relative creditworthiness of the various governments.

The large number of countries and therefore of potential sovereign borrowers makes it obviously desirable for comparative ratings to be done on a consistent basis by suitably skilled and experienced parties – this is the role played by the rating agencies.

It is generally agreed that bonds issued in a government’s own currency are safer than those issued in a foreign currency. This is because, when the RSA Government promises that it will repay its debt denominated in Rands, at the extreme it can always print more Rands in order to do so.

However, if the RSA Government borrows in US Dollars, it is unable to print Dollars to pay back this debt – it would have to use Rands to buy Dollars (or, often, raise a new Dollar-denominated loan to settle the one that is due for repayment).

As a result, the rating agencies distinguish between “Global scale foreign currency” ratings, “Global scale local currency” ratings, and “National scale” ratings. The first two are to allow international comparisons, and National ratings are to allow comparisons across borrowers within a country, relative to government debt in that country (which normally has a National scale rating of AAA). On the Global scale, a government’s local currency rating will sometimes be better than its foreign currency rating.

What is a downgrade?

The rating agencies each have a standard notation to assign ratings to borrowers. S&P, Fitch and GCR use the same notation, with AAA being the highest and therefore the best rating. Ratings of BBB- (“BBB-minus”) or above are usually described as “investment grade”, while BB or B ratings are sub-investment grade, commonly referred to as “junk” or “high yield” – in the agency’s judgment, investment-grade bonds are very or moderately safe investments, while sub-investment grade bonds are distinctly more risky.

A “C” rating indicates that the rating agency believes the borrower is close to defaulting, and a “D” rating indicates that the borrower has defaulted.

Over time, the rating agencies will review the ratings that they assign to borrowers, and borrowers may move up or down the scale. Moving down the scale, e.g. from AAA to AA, is a downgrade. More critically, moving from BBB- to a BB rating (BB+, BB or BB-) is a downgrade from investment grade to “junk” status.

The various agencies each make their own assessments and give independent ratings, where they are assessing the same borrower. Often their views will be largely the same, but sometimes they differ, though the differences are usually small.

Until recently, Moody’s, S&P and Fitch all rated the bonds of the South African government, whether denominated in Rands or foreign currency, as investment grade (BBB or BBB-).

However, following the cabinet reshuffle at the end of March, S&P and Fitch quickly downgraded South Africa’s foreign-currency debt to “junk” status (BB+). Fitch also downgraded our local-currency debt to “junk” on the Global scale, but S&P still maintains an investment-grade rating of BBB- for our Rand debt.

Moody’s still has investment-grade BBB ratings (“Baa2” using Moody’s notation) for both Rand and foreign-currency RSA debt, but is busy reviewing its ratings.

Why is a downgrade to junk status important?

By and large, lenders are not obliged to take account of the rating agencies’ ratings – they can ignore them if they wish. (There are exceptions, which we will explain below.)

In fact, one of the lessons of the Global Finance Crisis has been that investors – lenders – should not slavishly follow the agency ratings, without thinking for themselves. In South Africa, Regulation 28 to the Pension Funds Act says explicitly that a fund and its investment managers must not rely on credit agency ratings in isolation when making lending decisions, and should carry out their own due diligence.